What if I want to buy an ethical ETF? Pt 1 – Australian equities
Morningstar looks under the hood at four options for your portfolio.
Deciding which exchange-traded fund to buy can be bewildering, especially if you want it to be in line with your values. There are nine passively managed Australian equity exchange-traded funds (ETFs) that consider the environment, society and corporate governance in the companies they choose. But in the absence of a single definition for “good”, funds take different approaches to building their portfolios. With labels like “sustainable”, “ethical” or “responsible”, how do investors pick between them?
To help investors decide on one that aligns to their values, we examine the four largest domestic equity passive ETFs with a claim to ethics or sustainability. We look at how each measures sustainability, compare them to the benchmark S&P/ASX 200, talk to experts about the risks and trade-offs and assess performance and fees.
Over the following weeks we’ll also look at the options for international equity and fixed interest investors.
BetaShares Australian Sustainability Leaders ETF (ASX: FAIR) is the largest of the four, with $1.3 billion in assets. Rounding out the list are Vanguard’s Ethically Conscious Australian Shares (ASX: VETH), Russell Investors Australian Responsible Investment (ASX: RARI) and VanEck’s Australian Sustainable Equity (ASX: GRNV).
All are broad-market funds, meaning they hold tens or hundreds of stocks drawn from across the ASX. Those looking for funds investing solely in clean energy or other sustainable themes can read our review of local options funds here.
Four funds, four takes on sustainability
Portfolio managers take two broad approaches to building a sustainable or ethical index: cut out controversial industries such as alcohol and coal mining, and/or prioritise companies with good records on environmental, social and governance (ESG) issues.
Three of the funds, RARI, FAIR and GRNV, do both. They passively track custom indexes that use a broad two-step process to create a sustainable portfolio of Australian stocks.
First, the indexes exclude ASX stocks involved in controversial industries. Common exclusions include gambling, pornography, fossil fuels and weapons. BetaShares has the longest list of bans, followed by VanEck. FAIR won’t invest in firms involved in animal cruelty and asylum seeker detention centres; GRNV has a nutrition filter. All three also screen for major controversies, including ESG-related events that damage reputations or attract regulatory action.
The remaining stocks are then ranked according to a sustainability or ethical metric, a process called positive screening. VanEck and Russell Investments use ESG scores provided by third parties MSCI and Sustainalytics. BetaShares prioritises “sustainability leaders”, those earning more than 20% of revenue from sustainable activities and/or ticks from third-party watchdogs.
RARI additionally applies an income filter, screening for companies with high dividend yield.
Final decisions at FAIR and RARI are made by Responsible Investment Committees. A mix of internal and external members, they apply the screens and engage with companies over controversies or violations.
BetaShares says it excluded 14 companies during FAIR’s rebalance last year, including six predatory lenders and another three firms based on evidence presented at the Royal Commissions into Aged Care and Financial Services.
Bronze-rated VETH has a more limited approach. It excludes companies with “significant business activities” in fossil fuels, nuclear power, sin and weapons but does not positively screen. Severe controversies are a cause for removal.
FAIR rank highest for the sustainability of its holdings, with companies more likely to have lower ESG risk, according to Morningstar data. VanEck’s GRNV is second, followed by RARI and VETH.
Vanguard’s fund is the only one of the four without a “high” sustainability rating from Morningstar.
With funds taking different approaches, investors need to reflect and decide what companies they want to support, avoid, or don’t care about, says Paul Garner, a financial adviser at Novo Wealth and member of the Ethical Advisers Co-op. That makes it easier to find a fund that matches their values.
“Investors need to decide how ‘dark’ or ‘light green’ they are,” he says, referring to how central sustainability is to their investment approach.
Do you want to own the major banks and blue chips?
Distinct screens mean each fund holds a slightly different set of companies. Resources and financial hold similar weights in RARI and VETH as in the S&P/ASX 200. The VanEck and BetaShares funds stand out with greater tilts to technology and real estate versus the benchmark.
Australia’s small size does limit the options for funds managers and there is considerable overlap between the funds. For example, all four own Telstra, biotechnology giant CSL and real estate company Goodman Group.
Like the S&P/ASX 200, half of VETH’s and RARI’s portfolio is in basic materials and financial services. Major miners BHP and Rio Tinto are noticeably absences, but iron ore giant Fortescue Metals makes the cut. A quarter of each portfolio is tied up in the big four banks. Australia’s largest bank, Commonwealth Bank (ASX: CBA), takes up a tenth of each fund. VETH also excludes Woolworths Group.
Resources and financial are also the top two sectors among GRNV’s 100 holdings but major names are missing: no BHP or Rio Tinto and the only major bank included is ANZ. VanEck’s fund differs from the index with tilts to real estate, industrials and healthcare: steel maker BlueScope rubs shoulders with Sydney Airport. A large weight to basic materials is made up of Fortescue Metals, smaller miners and companies such as building materials company James Hardie.
Sustainable portfolios with big banks and miners highlight the difficulties of sustainable investing in Australia, says Nathan Fradley a senior adviser at Tribeca Financial.
“Part of the challenge in Australia is you’re often going to end up with the big four banks even though they lend to fossil fuel companies,” says Fradley.
“You’re going to end up with a resources and financials tilt in general because of the nature of the market. That’s the challenge in the domestic context because it’s a small market.”
FAIR’s stands out among the four with a distinct tilt to its 88 holdings. The fund owns a handful of lithium miners and some smaller banks, but no big four or major miners. Also gone are blue chip names such as Wesfarmers, Coles, Macquarie Group and toll-road operator Transurban.
Instead, the fund tilts towards healthcare, real estate and technology. Healthcare is the largest sector represented, with CSL, Sonic Healthcare and ResMed making up 12% of the fund. There is three times as much real estate and technology in the portfolio as the ASX 200.
Are you ok being “out of step” with the market?
Cutting out many Australian blue chips stocks leaves FAIR with more medium sized and growth-oriented holdings compared to the other funds.
The difference is relatively modest. Sixty-seven per cent of FAIR’s companies are giant or large, versus 72% for RARI, according to Morningstar data. FAIR correspondingly has a larger number of medium sized companies.
“Major part of the Australian indices are miners and the big four banks,” says Garner.
“If they’re a no go… you’re going to have more small to medium sized companies in your portfolio. That’s fine, however it increases the risk to a greater extent. Probably going to have more volatility, maybe better returns.”
Smaller companies and greater representation from sectors such as technology gives FAIR’s portfolio a greater tilt to growth relative to the other funds and the wider index, according to Morningstar’s classification system. Growth stocks tend to trade at higher prices on the expectation of rapid growth. They tend to pay fewer dividends than mature companies and may be less suitable for income investors.
Investors should note the fund’s performance may therefore differ from movements in the broader market, for better and worse, says Garner. The economic and financial factors that drive outperformance in mining or banking can differ from what moves technology and healthcare.
“You’ll be more out of step with the market. Temper your expectations. You won’t necessarily out or underperform, but it will be different,” he says.
In contrast, Morningstar senior manager research analyst Kongkon Gogoi says VETH’s performance more closely tracks the broader S&P/ASX 300 index.
Strong track records of performance so far
All four ETFs have benefited from last year’s bull run, posting double digit total returns that topped the ASX 200 in all cases but RARI.
GRNV had a total return of 19% in 2021, followed by 18.6% for VETH and 18% for FAIR. The Russell Investors fund lagged the pack at 16.5%, compared to a 17.2% total return for the benchmark.
Underperformance dogs RARI over the three-year horizon too, with an annualised return of 10.8% versus 14% and 15% at the other three funds.
Vanguard has the lowest fees on offer, charging 0.16% per annum versus fees of 0.35% at GRNV and 0.45% at RARI. The BetaShares fund charges the highest fees at 0.49%.
Fee differences add up over many years. Assuming a 6% return each year, someone investing $10,000 annually over a decade would pay roughly $1,000 in the Vanguard fund, versus $2,000 had they chosen FAIR.
Mixing and matching
For investors unable to decide, what about the merits of blending several options? Fradley says the smaller holdings in FAIR could pair with a second fund with an average market cap closer to the benchmark.
That echoes the view of Gogoi, who says more idiosyncratic funds like FAIR and GRNV are valuable as satellite holdings in a broader portfolio built around a core of funds that track the benchmark index closely.
But that raises the difficult question of how willing investors are to compromise on their ethical beliefs, says Garner. Investors with strict consciences unwilling to own major banks or miners need to accept the trade-offs associated with owning a different type of portfolio.
“It comes down to what you’re willing to compromise. If you’re dark green, I don’t think you have any choice. If those companies are non-negotiable, that’s what you have to do.”